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U.S. MarketFlash | Will the changes to lease accounting alter occupier behavior?

What U.S. Owners Need To Know In Advance Of The New Standard Being ​Implemented.

From the time lease accounting changes were first proposed by the Financial Accounting ​Standards Board (FASB) in 2010 until the final standard was issued in February 2016, much of the discussion has centered on the impact to occupiers. This is with good reason as the new standard will, among other things, require occupiers to:

Record ALL leases (including real estate) on their balance sheet, except leases of 12 months or less.

Include rent to be paid in option periods "reasonably certain" of being exercised in the amount recorded on the balance sheet.

Reassess over the term of the lease whether an option previously not "reasonably certain" of bring exercised has become "reasonably certain" or vice versa.

Lessor accounting remains largely unchanged by the new standard, but there will be an impact to owners as occupiers face a new set of considerations regarding their occupancy decisions. While we do not expect the new standard to have a major impact on occupiers' real estate leasing decisions, it may cause some occupiers to alter their behavior.

Although the effective dates for the new standard appear to be on the distant horizon—2019 for public companies and 2020 for private companies—companies can early adopt at any time. Additionally, since existing leases will not be grandfathered, leases executed today will impact an occupier’s financial statements because they must restate comparative periods in financial statements issued after the effective date. This means a public company will generally restate its balance sheet for the year immediately preceding the effective date, and its income statement for the two years preceding the effective date.

What can owners expect leading up to and upon implementation of the new standard? Below we highlight potential implications for owners in this new environment:

Greater corporate scrutiny of real estate portfolios: Given the impact of the new standard on balance sheets, corporate finance departments will likely become more engaged in leasing decisions, possibly resulting in longer lease negotiations and execution times.

Occupiers requesting a greater number of lease scenarios: Companies will likely request more alternatives from an owner when contemplating a lease, including varying lease terms, tenant improvement packages and renewal options. This matrix of options will allow them to identify the sweet spot where the lease’s economics and impact to the balance sheet intersect with the cost of and best use of capital.

Possible trend towards triple-net leases: The new standard allows for costs embedded in the lease, like operating expenses, taxes and insurance, to be segregated from the rent payment to arrive at the "net rent." This "net rent" is then used to determine the amount recorded on an occupier’s balance sheet. As a result, where possible, occupiers may trend towards negotiating triple-net rents to avoid the administrative burden of segregating their rent payments or, at a minimum, require the landlord to provide a breakout between the net rent and other costs embedded in the lease payment.

Increased interest in self-funding tenant improvements (TIs): As TIs incorporated into the rental rate will now effectively go on an occupier's balance sheet, there may be less of an impediment to self-funding TIs, thereby allowing an occupier to capture the spread between their cost of funds and the interest rate embedded in the lease.

Increased interest in the prospect of owning rather than leasing space: Although we do not expect a significant shift from leased to owned space, interest in ownership of core, single-tenant assets by strong credit tenants may increase with the end of off-balance sheet treatment for leases.

Possibility of occupiers considering shorter lease terms to minimize the impact to their balance sheet: While occupiers may explore reducing the length of their lease term and, "on the margin" some may do so, ultimately the requirement to capitalize leases will not be the deciding factor in the term of a lease. Rather, it will continue to be the efficient use of capital and what is in the best interests of the business.

Greater spotlight on workplace strategies: As the amount of square footage leased will directly impact the amount recorded on the balance sheet, the new standard may intensify the spotlight that already shines on an occupier’s efficient use of space.